Follow the Money From Pension Fund to Partner

Private equity makes money in two ways at once. The firm charges its investors a yearly management fee of around 2%, then takes around 20% of the profits, called carried interest, once the companies it bought are sold for more than it paid.

The fee is paid win or lose. The profit share is paid only when the deals work. Almost everything else in the industry, from leveraged buyouts to dividend recaps, is a tool for making that second paycheck bigger or arrive sooner.

This guide follows the money from the investors who supply it to the partners who keep it. If you want the full picture of how the industry works, from fund structures to regulation, start with FRC’s complete guide to how private equity actually works. FRC has no relationship with any private equity firm and earns no commission from any investment.

Follow the Money From Pension Fund to Partner

Every private equity fund has two sides. The private equity firm is the general partner, or GP, which finds the deals and runs the companies. The limited partners, or LPs, supply almost all of the money.

The GP puts in a small share of its own capital, typically somewhere between 1% and 5% of the fund. That stake gives the firm a direct interest in the result alongside its investors. But set it against a 20% share of the profits, and the GP’s reward is far larger than its cash at risk.

The rest comes from pension funds, endowments, insurers, sovereign wealth funds, family offices and wealthy individuals. So when people ask how private equity makes money, the honest first answer is: mostly with other people’s money.

Who Is Actually Paying

The fees and profit share come out of the LPs’ returns, and many LPs invest on behalf of ordinary people. A teacher’s pension plan that commits $200 million to a buyout fund is paying private equity fees with money set aside for retired teachers. The debt used to buy each company is paid by someone else again: the company itself, out of the cash its customers and employees generate.

Getting that money in the door is a regulated job. Interests in a private fund are securities, and the people who market them to investors, whether inside the firm or at an outside placement agent, generally work through a FINRA-registered broker-dealer. That is why capital-raising roles sit on the same licensing path as the rest of the securities industry.

The path starts with the Securities Industry Essentials exam, and FRC’s SIE Exam Preparation course covers the market structure, products and rules behind it. The Series 7 Exam Preparation course goes further, into the full range of securities a registered representative can sell. Both are open to everyone, whether you plan to raise capital or simply want to understand who is selling what to whom.

The Management Fee: Paid Win or Lose

The management fee is the steady income. During the investment period, usually the first five years or so, it is typically charged at 1.5% to 2% a year on the total capital investors have committed, not just the money already spent.

Take a $2 billion fund charging 2%. That is $40 million a year, or $200 million over a five-year investment period, before a single company has been sold. After the investment period, the fee often steps down, for example to a lower rate charged only on the capital still invested in companies. The largest funds often charge less than 2% from the start, because even a smaller percentage of a very large fund is a very large number.

The fee pays for the deal teams, offices, travel, lawyers and research. But at the largest firms, managing many funds at once, it also produces a large and predictable profit. That creates a quiet incentive: raising a bigger fund raises the fee, whether or not the returns improve.

Carried Interest: The Real Prize

Carried interest, or carry, is the GP’s share of the fund’s profits. The traditional rate is 20%. It is where the large fortunes in private equity are made.

Carry is not paid on day one. In most funds, investors must first receive all of their contributed capital back plus a preferred return, often called the hurdle, which is commonly 8% a year. Only after the hurdle is cleared does the GP start to share in the gains.

That design ties the firm’s biggest pay day to the investors’ results. A fund that merely returns its investors’ money earns the GP no carry at all, however many years of management fees it collected along the way.

The Distribution Waterfall, Step by Step

The order in which cash is paid out is called the distribution waterfall. Here is a simplified example, ignoring fees and timing differences between deals. A fund invests $1 billion and, five years later, has returned $1.8 billion, a profit of $800 million.

First, the LPs get their $1 billion back. Second, they receive the 8% preferred return compounded over five years, about $469 million. Third comes the catch-up: the GP receives 100% of the next distributions, about $117 million, until it has 20% of all profits paid out so far.

Fourth, the remaining $213 million is split 80% to the LPs and 20% to the GP. The final result: the GP takes $160 million, exactly 20% of the $800 million profit, and the LPs take $1.64 billion. The hurdle changed the timing, not the final split.

Funds use two main styles. A European, or whole-of-fund, waterfall pays carry only after investors have their money back across the entire fund. An American, or deal-by-deal, waterfall can pay carry on each successful deal as it is sold, which gets money to the GP sooner and makes a clawback clause essential.

Clawbacks: When the GP Has to Give Money Back

A clawback is a promise that the GP will return carry it was not entitled to. Suppose early deals sell well and carry is paid, then later deals fail and the fund as a whole falls short of the hurdle. The clawback requires the GP to hand back the excess.

In practice, clawbacks can be hard to enforce. The carry may already have been paid to individual partners and taxed. Many funds hold back part of the carry in escrow for that reason, releasing it only when the fund’s final result is known.

Where the Profits Come From in the First Place

Carry depends on profits, and profits come from the companies. A buyout makes money through three levers: growing earnings, paying down debt and selling at a higher valuation multiple. The best deals pull all three.

Here is a worked example. A firm buys a company earning $50 million a year in EBITDA, a common measure of operating profit, for 10 times earnings, or $500 million. It funds the deal with $200 million of equity and $300 million of debt.

Five years later, EBITDA has grown to $70 million and a buyer pays 11 times earnings, so the company sells for $770 million. Debt has been paid down to $200 million, leaving $570 million for the equity holders. A $200 million investment has become $570 million, 2.85 times the money, or about 23% a year.

Break that $370 million gain apart and the three levers appear. Earnings growth added $200 million, from $20 million more EBITDA valued at 10 times, while debt paydown added $100 million and the higher exit multiple added $70 million.

Earnings growth did most of the work here. In a weaker deal, a falling multiple or missed earnings can wipe the gain out just as fast.

How Earnings Actually Get Grown

Earnings growth is the lever firms control most directly, and the largest firms have built teams around it. Many employ operating partners, former chief executives and industry specialists who work inside portfolio companies alongside management.

The work is practical. It can mean raising prices where a company has been undercharging, renegotiating with suppliers, using the firm’s combined buying power across its portfolio, upgrading systems and reporting, or entering new markets. Add-on acquisitions can bring new customers and products faster than the company could build them alone.

Management teams are usually given a meaningful equity stake in the business. Their biggest payout then arrives at the same moment as the fund’s: when the company is sold for more than it cost. That shared pay day is one of the strongest tools a private equity owner has.

Leverage: Turning Modest Gains Into Big Multiples

Debt is what makes the equity return so large. In the example above, the company’s total value rose 54%, from $500 million to $770 million. The equity, carrying all the gains on a smaller base, rose 185%.

The debt sits on the company’s balance sheet, not the firm’s, and the company pays it back from its own cash flow. That is the core of the leveraged buyout, and FRC’s complete private equity guide, linked above, walks through what happens when the same leverage works in reverse.

For the GP, leverage has a second effect. Because carry is a share of profits, magnifying the equity gain magnifies the carry too. A deal that doubles investors’ money pays the GP far more than one that returns 1.3 times, even if the underlying businesses improved by similar amounts.

Buy-and-Build: Buying Small, Selling Big

Some firms make money by assembling a bigger company rather than improving a single one. In a buy-and-build strategy, the firm buys a platform business, then bolts on smaller competitors in the same industry.

The profit often comes from the gap in valuations. Small private businesses frequently sell at lower multiples of earnings than larger groups. Buy five small firms at 6 times earnings, combine them into one larger company, and a buyer may pay 9 or 10 times the combined earnings, before any cost savings are counted.

The risk is in the execution. Merging systems, teams and customers costs time and money, and paying too much for the add-ons can erase the multiple gap entirely.

Exits: When the Carry Is Actually Paid

Carry is earned on paper but paid in cash, and cash arrives at the exit. Most companies are sold to a strategic buyer, such as a competitor, or to another private equity firm in a secondary buyout. A listing through an initial public offering is a third route, used less often than most people assume.

That makes the exit market the bottleneck for private equity pay. As of June 30, 2026, PitchBook data showed 33,575 private equity-owned companies unsold worldwide, and Bain & Company puts the value of unsold portfolios at about $3.8 trillion. Bain reports the typical buyout is now held about seven years before it is sold.

Longer holds hurt the fee model in two ways. Investors wait longer for their money, which drags down returns and makes them slower to commit to the next fund. And partners wait longer for their carry, which is why continuation funds, recaps and partial sales have become so common.

Continuation Funds: A Second Round of Fees

A continuation fund lets a GP keep a company it likes after the original fund’s life runs out. The GP sells the company from the old fund into a new vehicle it also manages, with new investors buying in and existing investors choosing to cash out or roll their stake forward.

For the GP, the money can work twice. The sale can crystallize carry in the old fund, and the new vehicle usually comes with its own management fee and a fresh carry arrangement on the same company. The GP keeps earning on an asset it already owned.

That is why continuation funds draw close scrutiny. The GP sits on both sides of the sale and helps set the price, so investors typically look for an independent valuation, often a fairness opinion, and a competitive process before agreeing to the terms.

The Fees Investors Don’t See in the Headline

The 2 and 20 is only the headline. Private equity firms can also charge fees to the companies they own: transaction fees when a deal is completed, monitoring fees for ongoing advice, and fees for arranging financing or advising on an exit.

Those fees are paid by the portfolio company, and so indirectly by the fund’s investors who own it. To address that, many fund agreements include fee offsets, which reduce the management fee by a share of the portfolio company fees, sometimes all of them. How much is offset is one of the terms large investors negotiate hardest.

Funds can also pass on broken deal costs, the legal and due diligence bills for acquisitions that never complete. Those costs are often charged to the fund, which means the investors pay for the deals that fell through as well as the ones that closed.

The SEC has acted when these fees were not properly disclosed. In 2015, three Blackstone advisers agreed to pay nearly $39 million to settle charges that included accelerating monitoring fees when companies were sold, without adequately disclosing the practice to fund investors before they committed capital.

Disclosure rules have been contested since. In 2023, the SEC adopted new rules for private fund advisers, including quarterly statements detailing fees and expenses, but in June 2024 a federal appeals court vacated them. Fee transparency today rests mainly on fund agreements, Form ADV disclosures and the negotiating power of the investors.

Co-Investments: How Big Investors Pay Less

The largest investors have found a way to cut the bill. In a co-investment, an LP invests directly in a specific deal alongside the fund, usually with little or no management fee and little or no carry on that extra money.

The GP benefits too. Co-investment lets it complete a bigger deal without taking too much of the fund’s capital into one company, and it strengthens the relationship with investors it wants back for the next fund.

The result is that two investors in the same fund can pay very different blended fees. A large pension fund with co-investment rights may pay far less on its total private equity exposure than a smaller investor holding only the main fund.

Dividend Recaps and Subscription Lines: Getting Paid Sooner

Private equity returns are measured partly by speed, so firms have tools to return cash earlier. The dividend recapitalization is the best known. A portfolio company borrows new money and pays it out as a dividend to its owners, so the fund gets cash back without selling the business.

A less visible tool sits at the fund level. A subscription credit line lets the fund borrow short term to complete a deal, then call capital from investors weeks or months later. Investors’ money is at work for a shorter time, which can raise the fund’s reported annual return without changing how much money it actually made.

A third tool is the sale-leaseback, where a portfolio company sells property it owns and rents it back, releasing cash that can be paid out or used to reduce debt. The company then carries a new rent bill for years.

None of these tools creates value on its own. A recap moves debt onto the company, a sale-leaseback swaps an asset for a long-term cost, and a subscription line shifts timing. Investors who understand all three read a fund’s track record far more carefully.

IRR, MOIC and DPI: How Private Equity Keeps Score

Private equity uses three main numbers to describe performance. The internal rate of return, or IRR, measures the annual rate of return, taking timing into account. Cash returned sooner lifts it, which is why recaps and subscription lines matter.

The multiple on invested capital, or MOIC, ignores timing and simply compares money out with money in. Turning $200 million into $570 million is a 2.85x MOIC, whether it took three years or eight.

DPI, distributions to paid-in capital, measures the cash actually returned to investors so far. A fund can report a strong IRR on paper while its DPI stays low, because most of the value is still sitting in unsold companies. With exits slowing across the industry, DPI has become the number many pension funds now watch most closely.

How the Firms Themselves Make Money

Step back from a single fund and a private equity firm looks like a business with two income streams. Management fees across all its funds produce steady, predictable revenue. Carry produces large but irregular payouts, arriving when deals are sold.

Several of the biggest firms, including Blackstone, KKR, Apollo and Carlyle, are publicly listed. Their shareholders own the manager, not the funds, and analysts focus heavily on fee-related earnings because that income keeps flowing whatever the deal market does. Owning shares in a listed manager is one of the few ways ordinary investors can take part in the business of private equity.

Inside the firm, carry is shared among the partners and senior deal staff, usually vesting over several years. Junior professionals are paid mostly in salary and bonus, with carry becoming a larger part of pay with seniority. If you are thinking about working in the industry rather than investing in it, FRC’s guide on how to get into private equity covers the routes in.

When Private Equity Makes Money and Investors Don’t

The fee structure means a firm can do well while its investors do only modestly. Management fees are paid every year regardless of results. Portfolio company fees can be charged whether or not a deal succeeds.

Here is how fees and carry turn a gross result into a net one, in a simplified example. An investor commits $100 million. Over the fund’s life, about $10 million goes on management fees and expenses, so $90 million is actually invested in companies.

The deals perform well and return 2.0 times the money invested, or $180 million. Measured against the $100 million the investor paid in, the profit is $80 million. With the hurdle cleared and a full catch-up, the GP takes 20% of that, or $16 million, leaving the investor $164 million.

The deals made 2.0x. The investor made 1.64x. That gap, from fees and carry alone, is what every LP is really paying for, and it is why the same headline deal results can look very different in a pension fund’s own accounts.

Weaker funds feel it harder. A fund that returns 1.3 times its investors’ money over ten years can leave LPs with an annual return below what a low-cost stock index fund delivered over the same period, and it may never clear its hurdle. The GP still collected management fees throughout.

The difference between gross returns, before fees, and net returns, after fees, is the single most important number for anyone judging private equity performance. Large investors compare net returns against public market benchmarks for exactly this reason, and the same discipline applies to anyone weighing private equity against simpler options.

How Carried Interest Is Taxed

Carry is one of the most debated items in the US tax code. Because it is a share of investment profits, it can qualify as long-term capital gain, taxed at lower rates than ordinary salary income.

Since the Tax Cuts and Jobs Act of 2017, Section 1061 of the Internal Revenue Code requires the underlying assets to be held for more than three years for carry to receive long-term capital gains treatment. Gains on investments held for a shorter period are treated as short-term capital gains.

Critics argue carry is really payment for work and should be taxed like wages. Supporters argue it rewards entrepreneurial risk in the same way as other investment gains. Proposals to change the treatment surface regularly, so check the current rules before relying on any figure.

Can Ordinary Investors Share in the Profits?

Most private equity funds are open only to an accredited investor or, for many larger funds, a qualified purchaser. An individual generally qualifies as accredited with a net worth above $1 million, not counting their primary home, or with qualifying income. Holders of the Series 7, Series 65 or Series 82 license in good standing also qualify, whatever their wealth.

The minimum commitments are high and the money is locked up for years. Access through retirement plans is also changing: in March 2026, the Department of Labor proposed a safe harbor for 401(k) plan fiduciaries offering investment options that include private equity, so check the latest guidance before assuming your plan offers it.

There are other routes. Investors can buy shares in listed private equity managers, or funds that hold them, and FRC’s guide to private equity ETFs and what they actually hold explains what that exposure really is. Interval funds and business development companies offer other forms of access, each with its own fees and limits on when you can sell.

For a full walk-through of the direct and indirect routes, including what due diligence to do first, see FRC’s guide on how to invest in private equity funds. And if you are comparing private equity with other alternatives, FRC’s breakdown of private equity vs hedge funds vs venture capital shows how each one makes money differently.

The Rules Behind the Paycheck

Most private equity firms with $150 million or more in private fund assets in the United States must register with the SEC as investment advisers under the Investment Advisers Act of 1940. That brings a fiduciary duty to their funds, compliance programs and SEC examinations.

Fee practices are a regular focus of those examinations. Allocating expenses fairly between funds, disclosing portfolio company fees, and handling conflicts when a firm sits on both sides of a transaction, such as a continuation fund, all fall under the adviser’s duty of loyalty and care.

The funds themselves usually avoid registering as investment companies by limiting who can invest. That flexibility is what allows leverage, long lock-ups and the fee structures described in this guide, and it is also why access is restricted to investors the law considers able to bear the risk.

Common Questions

How does private equity make money? Private equity firms earn a management fee of around 2% a year on investors’ capital and carried interest of around 20% of the profits. The profits come from growing company earnings, paying down debt and selling companies at higher valuations.

What is 2 and 20 in private equity? It is the traditional fee model: a 2% annual management fee and a 20% share of profits, known as carried interest. Rates vary, and large investors often negotiate lower fees.

What is carried interest? Carried interest is the private equity firm’s share of a fund’s profits, usually 20%, typically paid only after investors have received their capital back plus a preferred return, often 8% a year.

Do private equity firms make money if the fund loses money? They still collect management fees, and may have collected portfolio company fees, but they earn no carried interest on a fund that fails to return its investors’ capital and preferred return.

Who pays private equity fees? The fund’s investors, the limited partners, pay them. Many of those investors are pension funds, endowments and insurers acting on behalf of ordinary savers and policyholders.

Learn How the Money Really Moves

Once you understand the fee model, every private equity headline reads differently. A record fundraise means a record stream of management fees. A dividend recap means cash out today and more debt tomorrow. A slow exit market means carry that partners are still waiting for.

FRC’s programmes and memberships are open to everyone. Whether you want to build a career in capital raising or simply understand where your pension is invested, the SIE and Series 7 preparation courses cover the rules behind the securities industry, and the FRC dictionary, with explainer videos on US financial regulation, is free for everyone.

For those building a career, FRC’s Professional Membership adds a verified Digital Profile that shows employers the courses you are studying and your real-time assessed progress, so your development is visible, not just described on a resume.

Private equity rewards people who understand the structure. Learn it first, and then judge every deal, fund and fee on its net result.